Lease Accounting Under Ind AS 116 PDF

 6.362 2. FINANCIAL REPORTING  362 UNIT 8: INDIAN ACCOUNTING STANDARD 116 : LEASES  LEARNING OUTCOMES  After studying this unit, you will be able to: ❑ List the scope an...

 6.362 2. FINANCIAL REPORTING  362 UNIT 8: INDIAN ACCOUNTING STANDARD 116 : LEASES  LEARNING OUTCOMES  After studying this unit, you will be able to: ❑ List the scope and explain the definitions given in the standard ❑ Comprehend the criteria for recognition of lease ❑ Analyse whether an arrangement contains a lease ❑ Identify and separate the lease and non-lease components of a contract ❑ Demonstrate the concept of inception and commencement of lease ❑ Determine lease term ❑ Identify other key concepts like lease payments, discount rate and economic life ❑ Provide the accounting in the books of lessee with respect to recognition, measurement, presentation and disclosure aspects ❑ Learn the accounting in the books of lessor with respect to recognition, measurement, presentation and disclosure aspects ❑ Produce accounting for subleases and sale and lease back transactions ❑ Apply the transitional provisions on applying Ind AS 116 for the first time.    © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  INDIAN ACCOUNTING STANDARD 116   6.363     UNIT OVERVIEW Ind AS 116 What is a Lessee Lessor Oveview Key concepts Other matters lease? accounting accounting Whether Inception and Initial Lease Objective arrangement commencemen recognitoin and Sub leases classification contains lease? t of lease measurment Separation of Subsequent Sales & Scope Finance lease lease and non- Lease term measurement leaseback lease components Recognition Operating Lease Remeasurment exemption lease Contract payments combinations Lease Modifications Discount rate modifications Presentation & Presentation & Initial direct disclosures disclosures cost Economic life Fair value  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  6.364 2. FINANCIAL REPORTING  364 8.1 OVERVIEW The Ministry of Corporate Affairs (MCA) has notified new standard on leases i.e Ind AS 116 vide its notification dated 30 th March, 2019. Lease accounting has undergone significant changes on introduction of Ind AS 116 which is fully converged with IFRS 16. This new standard replaced the erstwhile Ind AS 17 and is effective from financial periods beginning on or after 1 st April, 2019. Ind AS 17 was based on dual classification model of operating and finance leases with different classification and measurement guidance for each of them. The dual classification model did not account for the assets and liabilities associated with the rights and obligations that arise out of the most “operating” leases. Under Ind AS 116, leases are accounted for based on a ‘right-of-use model’. The model reflects that, at the commencement date, a lessee has a financial obligation to make lease payments to the lessor for its right to use the underlying asset during the lease term. The lessor conveys that right to use the underlying asset at lease commencement, which is the time when it makes the underlying asset available for use by the lessee. Ind AS 116, Leases, requires most leases to be recognized on the balance sheet and requires enhanced disclosures. It is believed that this will result in a more faithful representation of lessees’ assets and liabilities and greater transparency about the lessee’s obligations and leasing activities. However, Ind AS 116 does not make fundamental changes to existing lessor accounting model. 8.1.1 Objective The objective of this standard is to ensure that lessees and lessors provide relevant information in a manner that faithfully represents those transactions. This information gives a basis for users of financial statements to assess the effect that leases have on the financial position, financial performance and cash flows of an entity. This standard requires an entity to consider the terms and conditions of contracts and all relevant facts and circumstances, and to apply the standard consistently to contracts with similar characteristics and in similar circumstances. For many reporting entities, leasing is an important way to obtain access to property. A leasing arrangement conveys the use of an asset from one party to another without transferring ownersh ip. The leasing arrangement may take various forms. Some arrangements are clearly within the scope of lease accounting, for example, property lease that provides an explicit contractual right to use a building for a specified period of time in exchange for consideration. However, the right to use an asset can also be conveyed through arrangements that are not leases in form. Therefore, it is very critical to assess as to which arrangement contains a lease for assessing correct impact on financial position. Ind AS 116, Leases, identifies arrangements that are to be accounted for as leases. This unit discusses how to identify which arrangements, or components within an arrangement, should be  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  INDIAN ACCOUNTING STANDARD 116   6.365     accounted for under Ind AS 116 and sets out the principles for the recognition, measurement, presentation and disclosure of leases. 8.1.2 Scope Ind AS 116 shall be applied to ALL LEASES, including leases of Right-of-Use (ROU) assets in a sub-lease, EXCEPT for: S.N. Particulars Reason 1 Leases to explore for or use minerals, Within the scope of Ind AS 106 ‘Exploration oil, natural gas and similar non- for and Evaluation of Mineral Resources’ regenerative resources 2 Leases of biological assets held by a Within the scope of Ind AS 41 ‘Agriculture’ lessee 3 Service concession arrangements Within the scope of Appendix D of Ind AS 115 ‘Revenue from Contracts with Customers’ 4 Licences of intellectual property granted Within the scope of Ind AS 115 ‘Revenue by a lessor from Contracts with Customers’ 5# Rights held by a lessee under licensing Within the scope of Ind AS 38 ‘Intangible agreements for such items as motion Assets’ picture films, video recordings, plays, manuscripts, patents and copyrights #A lessee may, but is not required to, apply Ind AS 116 to leases of intangible assets other than those described herein. 8.1.3 Recognition Exemptions In addition to above scope exclusions, a lessee can elect not to apply Ind AS 116’s recognition requirements to: 1. Short-term leases; and 2. Leases for which the underlying asset is of low value If a lessee elects to apply the above recognition exemption, the lessee shall recognise the lease payments associated with those leases as an expense on either a straight-line basis over the lease term or another systematic basis, if that basis is more representative of the pattern of the lessee’s benefit.  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  6.366 2. FINANCIAL REPORTING  366 Short term leases: A short-term lease is a lease that, at the commencement date, has a lease term of 12 months or less and does not include an option to purchase the underlying asset. As the determination is made at the commencement date, a lease cannot be classified as short-term if the lease term is subsequently reduced to less than 12 months. The short-term lease exemption can be made by class of underlying asset to which the right of use relates. A class of underlying asset is a grouping of underlying assets of a similar nature and use in an entity’s operations. For example, consider an entity which has leased several items of office equipment - some of them for less than 12 months and some for more than 12 months, with none containing purchase options. Assuming that the items of office equipment are all considered to be of the same class if the entity wishes to use the short-term lease exemption it must apply for that exemption for all the leases with terms of 12 months or less. The leases with terms longer than 12 months will be accounted for in accordance with the general recognition and measurement requirements for lessees. A lessee that makes this election must make certain quantitative and qualitative disclosures about short-term leases. Once a lessee establishes a policy for a class of underlying assets, all future short-term leases for that class are required to be accounted for in accordance with the lessee’s policy. Illustration 1 - Short-term lease Scenario A: A lessee enters into a lease with a nine-month non-cancellable term with an option to extend the lease for four months. The lease does not have a purchase option. At the lease commencement date, the lessee is reasonably certain to exercise the extension option because the monthly lease payments during the extension period are significantly below market rates. Analyze whether the lessee can take a short-term exemption in accordance with Ind AS 116. Scenario B: Assume the same facts as Scenario A except, at the lease commencement date, the lessee is not reasonably certain to exercise the extension option because the monthly lease payments during the optional extension period are at what the lessee expects to be market rates and there are no other factors that would make exercise of the renewal option reasonably certain. Advise will your answer be different in this case. Solution: Scenario A: As the lessee is reasonably certain to exercise the extension option (Refer section 8.2 lease term), the lease term is greater than 12 months (i.e., 13 months). Therefore, the lessee will not account for the lease as a short-term lease.  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  INDIAN ACCOUNTING STANDARD 116   6.367     Scenario B: In this case, the lease term is less than 12 months, i.e., nine months. Thus, the lessee may account for the said lease under the short-term lease exemption, i.e., it recognises lease payments as an expense on either a straight-line basis over the lease term or another systematic basis. ***** Leases of low-value assets: Lessees can also make an election for leases for which the underlying asset is of low value (i.e., low-value assets). Though Ind AS 116 does not explicitly define the leases of low-value assets, it provides the conditions based on which an asset can be treated as of low-value and the said exemption can be availed accordingly for such low-value asset(s). Following are the conditions: An underlying asset can be of low value ONLY IF BOTH the following conditions are satisfied: The lessee can benefit from use of the underlying asset The underlying asset is not on its own or together with other resources that are highly dependent on, or highly readily available to the lessee interrelated with, other assets This can be understood with the help of the following example: An entity may lease a car for use in its business and the lease includes the use of the tyres attached to the car. To use the tyres for their intended purpose, they can only be used with the car and as such, they are dependent on, or highly interrelated with the car. Therefore, the tyres would not qualify for the low-value asset exemption. The election for leases for which the underlying asset is of low value can be made on a lease-by- lease basis. For example, an entity enters into a rental contract for a large number of laptops. Each laptop within the contract constitutes an identified asset. Entity has considered that the value of individual laptop would be low, even though the contract for all the laptops is not. The conditions of Para B5 of Ind AS 116 are satisfied i.e., the entity can benefit from use of an individual laptop together with other resources that are already available and each laptop does not need other assets to make it functional. Consequently, each laptop qualifies as a low value asset and the entity can elect to apply the low-value exemption to all the laptops under the contract.  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  6.368 2. FINANCIAL REPORTING  368 The exemption for leases of low — value items intend to capture leases that are high in volume but low in value — e.g. leases of small IT equipment (laptops, mobile phones, simple printers), leases of office furniture etc. Ind AS 116 is silent on any threshold to determine the value for classifying any asset as low value assets. The following boxes depicts the important points regarding the leases of low-value assets: Value of an underlying asset to be assessed based Leases of low-value assets are on the value of the asset when it is new, regardless exempted regardless of whether those of the age of the asset being leased* leases are material to the lessee Examples of low-value underlying assets can include: The assessment performed on an - tablet absolute basis. It is not affected by the - personal computers, size, nature or circumstances of the lessee. - small items of office furniture - telephones  * A lease of an underlying asset does not qualify as a lease of low value asset if the nature of the asset is such that, when new, the asset is typically not of low value. For e.g., leases of cars would not qualify as leases of low-value assets because a new car would typically not be of low value. Head leases do not qualify as low value assets: It is very important to note that if a lessee subleases an asset, or expects to sublease an asset, the head lease does not qualify as a lease of a low-value asset, i.e., an intermediate lessor who subleases, or expects to sublease an asset, cannot account for the head lease as a lease of a low-value asset. (Refer section 8.6.1 sublease) Then, what should be the approach for such leases when the said exemptions are taken? The lease payments shall be recognised as an expense on either a Straight -line basis over the lease term or another systematic basis, if that basis is more representative of the pattern of the lessee’s benefit. If a lessee accounts for “short-term leases” as per the approach mentioned above, it shall consider the lease to be a “new lease” for the purposes of Ind AS 116 if: (a) there is a lease modification; OR (b) there is any change in the lease term  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  INDIAN ACCOUNTING STANDARD 116   6.369     Recognition Exemptions Short-term leases Leases for which the underlying asset is of low-value A short-term A short-term ONLY IF BOTH the conditions lease is a lease lease does are satisfied that, at the not include an commencement option to date, has a purchase the The lessee can The underlying lease term of 12 underlying benefit from use of asset is not highly months or less asset the underlying asset dependent on, or on its own or together highly interrelated with other resources with, other assets that are readily This exemption can be made by available to the class of underlying asset (assets lessee of a similar nature and use) to which the right of use relates. Note: A lease cannot be classified as short-term The exemption can be made on if the lease term is subsequently reduced to less a lease-by-lease basis than 12 months Note: 1. The exemption for leases of low—value items intend to capture leases that are high in volume but low in value. 2. If a lessee subleases an asset, or expects to sublease an asset, the head lease does not qualify as a lease of a low-value asset, i.e., an intermediate lessor who subleases, or expects to sublease an asset, cannot account for the head lease as a lease of a low - value asset.     © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  6.370 2. FINANCIAL REPORTING  370 8.2 WHAT IS A LEASE? At the inception of a contract, an entity shall assess whether the contract is or contains a lease. For the purpose, a lease is defined as a contract, or part of a contract that conveys the right to control the use of an identified asset for a period of time in exchange for consideration. Ind AS 116 requires customers and suppliers to determine whether a contract is or contains a lease at the inception of the contract. The inception date is defined as the earlier of the following dates:  date of a lease agreement  date of commitment by the parties to the principal terms and conditions of the lease ‘A period of time’ may be described in terms of the amount of use of an identified asset ( for e.g., the number of production units that an item of equipment will be used to produce). It includes any non-consecutive periods of time.  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  INDIAN ACCOUNTING STANDARD 116   6.371     8.2.1 Whether an Arrangement Contains Lease? No Is there an identified asset? Yes Does the customer have right to obtain No substantially all of the economic benefits from the use of asset throughout the period of use? Yes Customer Does the customer or the supplier has the right to Supplier direct how and for what purpose the asset is used throughout the period of use? If predetermined then, whether the customer No Operates the asset? OR Designed the asset? Yes Contract Contract does contains a lease not contain a lease  Comparison with AS 19: AS 19 neither does provide additional guidance regarding “right to direct”, nor does it provide any guidance regarding cases of pre-determined activities. AS 19, in general, considers right to use an identified asset.  8.2.1.1 Identified Asset An arrangement only contains a lease if there is an identified asset. Under Ind AS 116, an identified asset can be explicitly specified in a contract or implicitly specified at the time that the asset is made available for use by the customer.  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  6.372 2. FINANCIAL REPORTING  372 Illustration 2 - Asset implicitly specified in a contract Customer XYZ enters into a ten-year contract with Supplier ABC for the use of rolling stock specifically designed for Customer XYZ. The rolling stock is designed to transport materials used in Customer XYZ’s production process and is not suitable for use by other customers. The rolling stock is not explicitly specified in the contract but Supplier ABC owns only one rolling stock that is suitable for Customer XYZ’s use. If the rolling stock does not operate properly, the contract requires Supplier ABC to repair or replace the rolling stock. Comment whether there is an identified asset. Solution: Yes, the said rolling stock is an identified asset. Though the rolling stock is not explicitly specified in the contract (e.g., by serial number), it is implicitly specified because Supplier ABC must use it to fulfil the contract. ΎΎΎΎΎ Illustration 3 (Asset implicitly specified in a contract): Customer XYZ enters into a ten-year contract with Supplier ABC for the use of a car. The specification of the car is specified in the contract (i.e., brand, type, colour, options, etc.). At inception of the contract, the car is not yet built. State whether there is an identified asset. Solution: Yes, the said car is an identified asset. Though the car cannot be identified at inception of the contract, it is implicitly specified at the time the same will be made available to Customer XYZ. ***** Substantive Substitution Rights: This is a very important concept since without evaluating this condition, the conclusion as to whether there is an identified asset cannot be attained. So, even if an asset is specified, a customer does not have the right to use an identified asset if, at inception of the contract, a supplier has the substantive right to substitute the asset throughout the period of use. A supplier’s right to substitute an asset is SUBSTANTIVE when BOTH of the following conditions are met:  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  INDIAN ACCOUNTING STANDARD 116   6.373     The supplier has the PRACTICAL ABILITY to substitute alternative assets throughout the period of use (for e.g., the customer cannot prevent the supplier from substituting an asset and alternative assets are readily available to the supplier or could be sourced by the supplier within a reasonable period of time). Substantive Substitution Rights The supplier would BENEFIT ECONOMICALLY from the exercise of its right to substitute the asset (i.e., the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset).  The conditions above are intended to differentiate between substitution rights that result in a supplier controlling the use of an asset, rather than the customer, and rights that do not change the substance or character of the contract. In the case of substitution rights, the analysis primarily considers factors from the supplier’s perspective. Examples of factors to consider include (1) transportation costs of relocating one asset to a location where it can be used to satisfy the arrangement or to move the output from the production location to the customer, (2) foregone production resulting from down time necessary to switch assets and other disruptions to the suppliers’ business, (3) excess operational costs to convert an asset that may not have produced identical output, etc. Further, if the supplier has a right or an obligation to substitute the asset only on or after either a particular date, or the occurrence of a specified event, the supplier’s substitution right is not substantive because the supplier does not have the practical ability to substitute alternative assets throughout the period of use. An entity’s evaluation of whether a supplier’s substitution right is substantive is based on facts and circumstances at inception of the contract. At inception of the contract, an entity should not consider future events that are not likely to occur. Ind AS 116 provides the following examples of circumstances that, at inception of the contract, are not likely to occur and, thus, are excluded from the evaluation of whether a supplier’s substitution right is substantive throughout the period of use:  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  6.374 2. FINANCIAL REPORTING  374 (1) (2) An agreement by a future customer to The introduction of new technology that is pay an above market rate for use of the not substantially developed at inception asset of the contract (3) (4) A substantial difference between the A substantial difference between the customer’s use of the asset, or the market price of the asset during the performance of the asset, and the use or period of use, and the market price performance considered likely at considered likely at inception of the inception of the contract contract The requirement that a substitution right must benefit the supplier economically in order to be substantive is a new concept. In many cases, it will be clear that the supplier will not benefit from the exercise of a substitution right because of the costs associated with substituting an asset. The physical location of the asset may affect the costs associated with substituting the asset. For e.g., if an asset is located at the customer’s premises, the cost associated with substituting it is generally higher than the cost of substituting a similar asset located at the supplier’s premises. However, simply because a supplier concludes that the cost of substitution is not significant does not automatically mean that it would economically benefit from the right of substitution. Ind AS 116 further clarifies that a customer should presume that a supplier’s substitution right is not substantive when the customer cannot readily determine whether the supplier has a substantive substitution right. This requirement is intended to clarify that a customer is not expected to exert undue effort to provide evidence that a substitution right is not substantive. However, suppliers should have sufficient information to make a determination of whether a substitution right is substantive. Contract terms that allow or require a supplier to substitute alternative assets only when the underlying asset is not operating properly (for e.g., a normal warranty provision) or when a technical upgrade becomes available do not create a substantive substitution right. Illustration 4 - Substantive Substitution Rights Scenario A: An electronic data storage provider (supplier) provides services through a centralised data centre that involve the use of a specified server (Server No. 10). The supplier maintains many identical  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  INDIAN ACCOUNTING STANDARD 116   6.375     servers in a single accessible location and determines, at inception of the contract, that it is permitted to and can easily substitute for another server without the customer’s consent throughout the period of use. Further, the supplier would benefit economically from substituting an alternative asset, because doing this would allow the supplier to optimize the performance of its network at only a nominal cost. In addition, the supplier has made clear that it has negotiated this right of substitution as an important right in the arrangement, and the substitution right affected the pricing of the arrangement. Analyze whether the substitution rights are substantive and whether there is an identified asset. Scenario B: Assume the same facts as in Scenario A except that Server No. 10 is customized, and the supplier does not have the practical ability to substitute the customized asset throughout the period of use. Additionally, it is unclear whether the supplier would benefit economically from sourcing a similar alternative asset. Analyze whether the substitution rights are substantive and whether there is an identified asset. Solution Scenario A: The customer does not have the right to use an identified asset because, at the inception of the contract, the supplier has the practical ability to substitute for the server and would benefit economically from such a substitution. Thus, there is no identified asset. However, if the customer could not readily determine whether the supplier had a substantive substitution right (for e.g., there is insufficient transparency into the supplier’s operations), the customer would presume the substitution right is not substantive and conclude that there is an identified asset. Scenario B: The substitution right is not substantive, and Server No. 10 would be an identified asset because the supplier does not have the practical ability to substitute the asset and there is no evidence of economic benefit to the supplier for substituting the asset. In this case, neither of the conditions of a substitution right is met (whereas both the conditions must be met for the supplier to have a substantive substitution right). Therefore, Server No 10 will be considered as an identified asset. *****  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  6.376 2. FINANCIAL REPORTING  376 Comparison with AS 19: AS 19 does not include any requirement for substantive substitution right. Hence, even if a lessor has substantial substitution right, the contract may be accounted for as a lease under AS 19. Identified Asset – Physically Distinct: An identified asset must be physically distinct. A physically distinct asset may be an entire asset or a portion of an asset. For example, a building is generally considered physically distinct, but one floor within the building may also be considered physically distinct if it can be used independent of the other floors. Similarly, a capacity or other portion of an asset that is not physically distinct (for e.g., a capacity portion of a fibre optic cable) is not an identified asset unless it represents substantially all of the capacity of the asset and thereby provides the customer with the right to obtain substantially all of the economic benefits from use of the asset. The term “substantially all” is not defined in Ind AS 116. This can be better understood with the help of the following illustrations: Illustration 5 (Identified Asset – Physically Distinct): Customer XYZ enters into a 15-year contract with Supplier ABC for the right to use five fibres within a fibre optic cable between Mumbai and Pune. The contract identifies five of the cable’s 25 fibres for use by Customer XYZ. The five fibres are dedicated solely to Customer XYZ’s data for the duration of the contract term. Assume that Supplier ABC does not have a substantive substitution right. Examine whether there is an identified asset. Solution: Yes, the said five fibres are identified assets because they are physically distinct and explicitly specified in the contract. ΎΎΎΎΎ Illustration 6 (Identified Asset – Not Physically Distinct): Scenario A: Customer XYZ enters into a ten-year contract with Supplier ABC for the right to transport oil from India to Bangladesh through Supplier ABC’s pipeline. The contract provides that Customer XYZ will have the right to use of 95% of the pipeline’s capacity throughout the term of the arrangement. Examine whether there is an identified asset.  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  INDIAN ACCOUNTING STANDARD 116   6.377     Scenario B: Assume the same facts as in Scenario A, except that Customer XYZ has the right to use 65% of the pipeline’s capacity throughout the term of the arrangement. Assess whether there is an identified asset. Solution: Scenario A: Yes, the capacity portion of the pipeline is an identified asset. While 95% of the pipeline’s capacity is not physically distinct from the remaining capacity of the pipeline, it represents substantially all of the capacity of the entire pipeline and thereby provides Customer XYZ with the right to obtain substantially all of the economic benefits from use of the pipeline. Scenario B: No, the capacity portion of the pipeline is NOT an identified asset. Since 65% of the pipeline’s capacity is less than substantially all of the capacity of the pipeline, Customer XYZ does not have the right to obtain substantially all of the economic benef its from use of the pipeline. ***** 8.2.1.2 Right to Control To assess whether a contract conveys the right to control the use of an identified asset for a period of time, an entity shall assess whether, throughout the period of use, the customer has both of the following: (a) The right to obtain substantially all of the economic benefits from use of the identified asset; and (b) The right to direct the use of the identified asset The right to control the use of an asset may not necessarily be documented, in form, as a lease agreement. Often, the right to use an identified asset is embedded in an arrangement that may appear to be a supply arrangement or service contract. Therefore, a reporting entity should consider all of the terms of an arrangement to determine whether it contains a lease. Further, if the customer has the right to control the use of an identified asset for only a portion of the term of the contract, the contract contains a lease for that portion of the term.  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  6.378 2. FINANCIAL REPORTING  378 Illustration 7 (Right to use for a portion of the term of contract): ABC Ltd enters into a contract with XYZ Ltd, which grants ABC Ltd exclusive rights to use a specific grain storage facility over a five-year period in the months of May and June. During these months, ABC Ltd has the right to decide which crops are placed in storage and when to remove them. XYZ Ltd provides the loading and unloading services for the warehouse activities. During the other ten months each year, XYZ Ltd has the right to determine how the warehouse will be used. Recommend which party has the right to control the use of the identified asset during the period of use. Solution: In the above case, ABC Ltd has the right to control the use of the identified asset during the period of use because they have the power to determine how the warehouse will be used during the contractually defined usage periods. The analysis should focus on the rights and economics of the use of the warehouse for the specified usage periods (May and June). During the period of use, ABC Ltd has the rights to determine how much of a crop to place in storage, and the timing of placing and removing it from storage. These rights are more significant to the economics of the use of the asset than the loading and unloading services performed by XYZ Ltd during the same period. ABC Ltd receives all of the economic benefit from use of the asset during those specified time periods. Therefore, contract contains a lease for the specified period of term. ΎΎΎΎΎ Right to Obtain Substantially All of the Economic Benefits: The first criterion in the control assessment is to determine whether the customer has the right to obtain substantially all of the economic benefits from use of the asset throughout the period of use, i.e., to control the use of an identified asset, a customer is required to have the right to obtain substantially all of the economic benefits from use of the identified asset throughout t he period of use (for e.g., by having exclusive use of the asset throughout that period). A customer can obtain economic benefits either directly or indirectly (for e.g., by using, holding or subleasing the asset). Economic benefits from use of an asset include:  the asset’s primary outputs (i.e., goods or services)  any by-products (for e.g., renewable energy credits that are generated through the use of the asset), including potential cash flows derived from these items.  benefits from using the asset that could be realised from a commercial transaction with a third party (for e.g., subleasing the asset)  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  INDIAN ACCOUNTING STANDARD 116   6.379     When assessing whether the customer has the right to obtain substantially all of the economic benefits from the use of an asset, an entity must consider the economic benefits that result from use of the asset within the defined scope of the customer’s right to use the asset. For example: (a) if a contract limits the use of a motor vehicle to only one particular territory d uring the period of use, an entity considers only the economic benefits from use of the motor vehicle within that territory, and not beyond; or (b) if a contract specifies that a customer can drive a motor vehicle only up to a particular number of miles during the period of use, an entity considers only the economic benefits from use of the motor vehicle for the permitted mileage, and not beyond. A right that solely protects the supplier’s interest in the underlying asset (for e.g., limits on the number of miles a customer can drive a supplier’s vehicle as explained in the above example) does not, in and of itself, prevent the customer from obtaining substantially all of the economic benefits from use of the asset and, therefore, are not considered when assessing whether a customer has the right to obtain substantially all of the economic benefits. If a contract requires a customer to pay the supplier or another party a portion of the cash flows derived from the use of an asset as consideration (for e.g., if the customer is required to pay the supplier a percentage of sales from use of retail space as consideration for that use), that requirement does not prevent the customer from having the right to obtain substantially all of the economic benefits from use of the retail space. This is because the cash flows arising from those sales are considered to be economic benefits that the customer obtains from use of the retail space, a portion of which it then pays to the supplier as consideration for the right to u se that space. Illustration 8 (Right to obtain substantially all of the economic benefits): Company MNO enters into a 15-year contract with Power Company PQR to purchase all of the electricity produced by a new solar farm. PQR owns the solar farm and will receive tax credits relating to the construction and ownership of the solar farm, and MNO will receive renewable energy credits that accrue from use of the solar farm. Examine who has the right to substantial benefits from the solar farm. Solution: Company MNO has the right to obtain substantially all of the economic benefits from use of the solar farm over the 15-year period because it obtains:  the electricity produced by the farm over the lease term — i.e. the primary product from use of the asset; and  the renewable energy credits — i.e. the by-product from use of the asset.  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  6.380 2. FINANCIAL REPORTING  380 Although PQR receives economic benefits from the solar farm in the form of tax credits, these economic benefits relate to the ownership of the solar farm. The tax credits do not relate to use of the solar farm and therefore are not considered in this assessment. ΎΎΎΎΎ Right to Direct the Use of the Identified Asset The second criterion in the control assessment is to determine whether the customer has the right to direct the use of the identified asset throughout the period of use. Decisions about how and for what purpose an asset will be used are the most relevant factors to consider when assessing which party directs the use of the identified asset. Because such rights determine the economic benefits that can be derived from using the asset during the period of use. Decisions regarding where and when the asset is to be used are likely to be more important than how those decisions are implemented. For example, if a customer outsources operation of an asset to an outside service provider, the outsourcing does not typically influence the economic benefits that can be derived from the asset. In some arrangements, the decisions related to how and for what purpose an as set is used, are already specified in the contract before the lease term commences. These decisions will need to be considered in conjunction with decisions made during the period of use to properly identify the party that directs the assets’ use. Simply specifying the output prior to the term does not, on its own, constitute the ability to direct the use. The following figure illustrates the analysis that should be used to determine which party has the right to direct the use of an identified asset.  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  INDIAN ACCOUNTING STANDARD 116   6.381     Identify the rights that are most relevant to changing how and for what purpose the asset is used (i.e., those that affect the economic benefits to be derived from the asset)  No Are the decisions made related to Does the customer hold the the rights identified above rights? predetermined? No Yes  Yes Yes Does the customer have the right to The customer has the right to operate [or direct others to operate] the direct the use of the asset asset throughout the period of use without supplier having right to change those operating instructions?  Yes  No  Did the customer design the asset in a way that determined how and for  what purpose the asset will be used throughout the period of use? No The supplier has the right to direct the use of the asset  A customer has the right to direct the use of an identified asset whenever it has the right to direct how and for what purpose the asset is used throughout the period of use (i.e., it can change how and for what purpose the asset is used throughout the period of use). How and for what purpose an asset is used is a SINGLE CONCEPT (i.e., ‘how’ an asset is used is not assessed separately from ‘for what purpose’ an asset is used). When evaluating whether a customer has the right to change how and for what purp ose the asset is used throughout the period of use, the focus should be on whether the customer has the decision-making rights that will most affect the economic benefits that will be derived from the use of the asset. The decision-making rights that are most relevant are likely to depend on the nature of the asset and the terms and conditions of the contract.  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  6.382 2. FINANCIAL REPORTING  382 Ind AS 116 provides the following examples of decision-making rights that grant the right to change how and for what purpose an asset is used: Particulars Examples The right to change the type of output (i) Deciding whether to use a shipping container to that is produced by the asset transport goods or for storage (ii) Deciding on the mix of products sold from a retail unit The right to change when the output is Deciding when an item of machinery or a power plant produced will be used The right to change where the output is (i) Deciding on the destination of a truck or a ship produced (ii) Deciding where a piece of equipment is used or deployed The right to change whether the output Deciding whether to produce energy from a power is produced and the quantity of that plant and how much energy to produce from that output power plant Although the decisions about maintaining and operating the asset are often essential to the efficient use of that asset, the right to make those decisions, in and by itself, does not result in the right to change how and for what purpose the asset is used throughout the period of use. The customer does not need the right to operate the underlying asset to have the right to direct its use, i.e., the customer may direct the use of an asset that is operated by the supplier’s personnel. However, the right to operate an asset will often provide the customer with the right to direct the use of the asset if the relevant decisions about how and for what purpose the asset is used are predetermined. The relevant decisions about how and for what purpose an asset is used are predetermined: In some cases, it will not be clear whether the customer has the right to direct the use of the identified asset. This could be the case when  the most relevant decisions about how and for what purpose an asset is used are predetermined by contractual restrictions on the use of the asset (for e.g., the decisions about the use of the asset are agreed to by the customer and the supplier in negotiating the contract, and those decisions cannot be changed) OR  the most relevant decisions about how and for what purpose an asset is used are, in effect, predetermined by the design of the asset  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  INDIAN ACCOUNTING STANDARD 116   6.383     In cases where the decisions about how and for what purpose an asset is used are predetermined, a customer has the right to direct the use of an identified asset throughout the period of use when the customer either:  Has the right to operate the asset, OR direct others to operate the asset in a manner it determines, throughout the period of use without the supplier having the right to change those operating instructions OR  Designed the asset (or specific aspects of the asset) in a way that predetermines how and for what purpose the asset will be used throughout the period of use. Significant judgement may be required to assess whether a customer designed the asset (or specific aspects of the asset) in a way that predetermines how and for what purpose the asset will be used throughout the period of use. Specifying the output of an asset before the period of use If a customer can only specify the output from an asset before the beginning of the period of use and cannot change that output throughout the period of use, the customer do es not have the right to direct the use of that asset unless it designed the asset, OR specific aspects of the asset. If the customer did not design the asset or aspects of it, the customer’s ability to specify the output in a contract that does not give it any other relevant decision-making rights relating to the use of the asset (for e.g., the ability to change when, whether and what output is produced) gives the customer the same rights as any customer that purchases goods or service s in an arrangement (i.e., a contract that does not contain a lease). Protective rights A supplier’s protective rights, in isolation, do not prevent the customer from having the right to direct the use of an identified asset. Protective rights typically define the scope of the customer’s right to use the asset without removing the customer’s right to direct the use of the asset. Protective rights are intended to protect a supplier’s interests. For example, a contract may (i) specify the maximum amount of use of an asset or limit where or when the customer can use the asset, (ii) require a customer to follow particular operating practices, or (iii) require a customer to inform the supplier of changes in how an asset will be used. Protective rights typically define the scope of the customer’s right of use but do not, in isolation, prevent the customer from having the right to direct the use of an asset.  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  6.384 2. FINANCIAL REPORTING  384 Illustration 9 - Right to direct the use of an asset Customer X enters into a contract with Supplier Y to use a vehicle for a five-year period. The vehicle is identified in the contract. Supplier Y cannot substitute for another vehicle unless the specified vehicle is not operational (for e.g., if it breaks down). Under the contract: Customer X operates the vehicle (i.e., drives the vehicle) or directs others to operate the vehicle (for e.g., hires a driver). Customer X decides how to use the vehicle (within contractual limitations). For example, throughout the period of use, Customer X decides where the vehicle goes, as well as when or whether it is used and what it is used for. Customer X can also change these decisions throughout the period of use. Supplier Y prohibits certain uses of the vehicle (for e.g., moving it overseas) and modifications to the vehicle to protect its interest in the asset. Sate whether Customer X has the right to direct the use of the vehicle throughout the period of lease. Solution: Yes, Customer X has the right to direct the use of the identified vehicle throughout the period of use because it has the right to change how the vehicle is used, when or whether the vehicle is used, where the vehicle goes and what the vehicle is used for. Supplier Y’s limits on certain uses for the vehicle and modifications to it are considered protective rights that define the scope of Customer X’s use of the asset, but do not affect the assessment of whether Customer X directs the use of the asset. ***** Illustration 10 - Right to direct the use of an asset Entity A contracts with Supplier H to manufacture parts in a facility. Entity A designed the facility and provided its specifications. Supplier H owns the facility and the land. Entity A specifies how many parts it needs and when it needs the parts to be available. Supplier H operates the machinery and makes all operating decisions including how and when the parts are to be produced, as long as it meets the contractual requirements to deliver the spe cified number on the specified date. Assuming supplier H cannot substitute the facility and hence is an identified asset. Examine which party has the right to control the use of the identified asset (i.e., equipment) during the period of use.  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  INDIAN ACCOUNTING STANDARD 116   6.385     Solution: Entity A does not direct the use of the asset that most significantly drives the economic benefits because Supplier H determines how and when the equipment is operated once the contract is signed. Therefore, Supplier H has the right to control the use of t he identified asset during the period of use. Although Entity A stipulates the product to be provided and has input into the initial decisions regarding the use of the asset through its involvement in the design of the asset, it does not have decision making rights over how and for what purpose the asset will be used over the asset during the period of use. This arrangement is a supply agreement, not a lease. ***** Illustration 11 - Right to direct the use of an asset Entity L enters into a five - year contract with Company A, a ship owner, for the use of an identified ship. Entity L decides whether and what cargo will be transported, and when and to which ports the ship will sail throughout the period of use, subject to restrictions specified in the contract. These restrictions prevent Entity L from sailing the ship into waters at a high risk of piracy or carrying explosive materials as cargo. Company A operates and maintains the ship and is responsible for safe passage. State who has the right to direct the use of the ship during the period of use. Solution: Entity L has the right to direct the use of the ship. The contractual restrictions are protective rights. In the scope of its right of use, Entity L determines how and for what purpose the ship is used throughout the five — year period because it decides whether, where and when the ship sails, as well as the cargo that it will transport. Entity L has the right to change these decisions throughout the period of use. Therefore, the contract contains a lease. *****  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  6.386 2. FINANCIAL REPORTING  386 The concept explained in para 8.2.1 has been summarised as follows: Leases Identified asset Customer has right to control the use throughout the period of use Supplier has NO Right to obtain Right to Explicitly / substantive rights to substantially all direct the use implicitly substitute the asset economic benefits shall specified accrue to customer from use of an asset These are decision making rights for The supplier has The supplier would Directly or assessing which NO PRACTICAL NOT BENEFIT indirectly by party directs the use ABILITY to ECONOMICALLY* using, holding of the identified substitute from the exercise of or sub-leasing asset alternative assets its right to substitute the asset throughout the the asset period of use It includes primary There should output and by - be a products (including commercial potential cash flows *The economic benefits transaction derived from these associated with with a third items) substituting the asset are party expected to exceed the costs associated with substituting the assets Either Or Or How What Where When Operating rights Designing rights These rights should vest with customer *The economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  INDIAN ACCOUNTING STANDARD 116   6.387     Note: 1. In the case of substitution rights, the analysis primarily considers factors from the supplier’s perspective. 2. If the supplier has a right or an obligation to substitute the asset only on or after either a particular date, or the occurrence of a specified event, the supplier’s substitution right is not substantive because the supplier does not have the practical ability to substitute alternative assets throughout the period of use. 3. An entity’s evaluation of whether a supplier’s substitution right is substantive is based on facts and circumstances at inception of the contract. At inception of the contract, an entity should not consider future events that are not likely to occur. 4. Contract terms that allow or require a supplier to substitute alternative assets only when the underlying asset is not operating properly (for e.g., a normal warranty provision) or when a technical upgrade becomes available do not create a substantive substitution right. 5. Circumstances that, at inception of the contract, are not likely to occur and, thus, are excluded from the evaluation of whether a supplier’s substitution right is substantive throughout the period of use. 6. The right to control the use of an asset may not necessarily be doc umented, in the form as a lease agreement. 7. Ind AS 116 further clarifies that a customer should presume that a supplier’s substitution right is not substantive when the customer cannot readily determine whether the supplier has a substantive substitution right. This requirement is intended to clarify that a customer is not expected to exert undue effort to provide evidence that a substitution right is not substantive. 8. An identified asset must be physically distinct. A physically distinct asset may be an entire asset or a portion of an asset. Similarly, a capacity or other portion of an asset that is not physically distinct is not an identified asset unless it represen ts substantially all of the capacity of the asset and thereby provides the customer with the right to obtain substantially all of the economic benefits from use of the asset. 8.2.2 Separation of Lease and Non-Lease Components 8.2.2.1 Identifying and separating lease components of a contract Sometimes, there are contracts that contain rights to use multiple assets (for e.g., a building and an equipment, multiple pieces of equipment, etc.). The right to use each such asset is considered as a ‘separate’ lease component ONLY IF BOTH the following conditions are satisfied:  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  6.388 2. FINANCIAL REPORTING  388  The lessee can benefit from the use of the asset either on its own OR together with other resources that are readily available to the lessee (i.e., goods or services that are sold or leased separately, by the lessor or other suppliers, or that the lessee has already obtained from the lessor or in other transactions or events) AND  The underlying asset is neither highly dependent on, nor highly interrelated with, the other underlying assets in the contract. If one or both of these criteria are not met then, the right to use multiple assets is considered a ‘single’ lease component, i.e., not a ‘separate’ lease component. Identifying and separating lease components of a contract The right to use each asset is considered as a ‘separate’ lease component ONLY IF BOTH the following conditions are satisfied The lessee can benefit from the use The underlying asset is neither highly of the asset either on its own OR dependent on, nor highly interrelated together with other resources that are with, the other underlying assets in readily available to the lessee the contract Note: If one or both criteria are not met then, the right to use multiple assets is considered a s a ‘single’ lease component, i.e., not a ‘separate’ lease component  Let us have a look at the following illustration to have a better understa nding: Illustration 12 - Identifying and separating lease components Scenario A: A lessee enters a lease of an excavator and the related accessories ( for e.g., excavator attachments) that are used for mining purposes. The lessee is a local mining company that intends to use the excavator at a copper mine. State how many lease and non-lease components are there.   © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  INDIAN ACCOUNTING STANDARD 116   6.389     Scenario B: Assume the same facts as in Scenario A, except that the contract also conveys the right to use an additional loading truck. This loading truck could be deployed by the lessee for other uses (for e.g., to transport iron ores at another mine). Solution: Scenario A: The lessee would be unable to benefit from the use of the excavator without also using the accessories. Therefore, the excavator is dependent upon the accessories. Thus, from the perspective of the lessee, the contract contains one lease component. Scenario B: The lessee can benefit from the loading truck on its own or together with other readily available resources because the loading truck could be deployed for other uses independent of the excavator. The lessee can also benefit from the use of the excavator on its own or together with other readily available resources. Thus, from the perspective of the lessee, the contract contains two lease components, viz., a lease of the excavator (together with the accessories) and a lease of the loading truck. ***** 8.2.2.2. Separating lease components from non-lease components: There may be many contracts containing a lease coupled with an agreement to purchase or sell other goods or services (i.e., the non-lease components under Ind AS 116). For example, a supplier may lease a truck and also operate the leased asset on behalf of a customer (i.e., provide a driver). This service is not related to securing the use of the truck. The only items that contribute to securing the output of the asset are lease components. In this example, only the use of the truck is considered a lease component. Similarly, costs incurred by a supplier to provide maintenance on an underlying asset, as well as the materials and supplies consumed as a result of the use of the asset, are not lease components. The non-lease components are identified and accounted for separately from the lease component in accordance with other standards. For e.g., the non-lease components may be accounted for as executory arrangements by lessees (customers) or as contracts subject to Ind AS 115 by lessors (suppliers). Costs related to property taxes and insurance do not involve the transfer of a good or service. Consequently, if these costs are fixed in the contract, they should be included in the overall contract consideration to be allocated to the lease and non-lease components. Lessee reimbursements – whether a separate component of a contract? As already discussed above that under Ind AS 116, payments for maintenance activities, including common area maintenance (for e.g., cleaning the common areas of a building, removing snow  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  6.390 2. FINANCIAL REPORTING  390 from a car park for employees and customers) and other goods or services transferred to the lessee (for e.g., providing utilities or rubbish removal) are considered as non-lease components because they provide the lessee with a service. But, in some leases, a lessee also may reimburse (or make certain payments on behalf of) the lessor that relate to the leased asset for activities and costs that do not transfer a good or service to the lessee (for e.g., payments made for real estate taxes that would be owed by the lessor regardless of whether it leased the building and regardless of who the lessee is). Under Ind AS 116, such costs are not separate components of the contract because they do not represent payments for goods or services and are cons idered to be part of the total consideration that is allocated to the separately identified components of the contract (i.e., the lease and non-lease components, if any). Illustration 13 - Identifying different components in the contract Entity L rents an office building from Landlord M for a term of 10 years. The rental contract stipulates that the office is fully furnished and has a newly installed and tailored HVAC system. It also requires Landlord M to perform all common area maintenance (CAM) during the term of the arrangement. Entity L makes a single monthly rental payment and does not pay for the maintenance separately. The office building has a useful life of 40 years and the HVAC system and office furniture each has a life of 15 years. State what are the units of account in the lease. Solution: There are three components in the arrangement – the building assets (office building and HVAC), the office furniture, and the maintenance agreement. The office building and HVAC system are one lease component because they cannot function independently of each other. The HVAC system was designed and tailored specifically to be integrated into the office building and cannot be removed and used in anothe r building without incurring substantial costs. These building assets are a lease component because they are identified assets for which Entity L directs the use. The office furniture functions independently and can be used on its own. It is also a lease component because it is a group of distinct assets for which Entity L directs the use. The maintenance agreement is a non-lease component because it is a contract for service and not for the use of a specified asset. ***** Optional exemption of using Practical Expedient to not to separate non-lease component Ind AS 116 provides a practical expedient that permits lessees to make an accounting policy election, by CLASS OF UNDERLYING ASSET, to account for each separate lease component  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  INDIAN ACCOUNTING STANDARD 116   6.391     of a contract and any associated non-lease components as a SINGLE LEASE COMPONENT. It is important to note that such practical expedient is not permissible for lessor. Making this election relieves the lessee of the obligation to perform a pricing allocation, although it will increase the total lease liability to be recorded on its balance sheet. This expedient is not available for lessors. Lessees that make the policy election to account for each separate lease component of a contract and any associated non-lease components as a SINGLE LEASE COMPONENT, allocate ALL of the contract consideration to the lease component. It is very important to note that the practical expedient does not allow lessees to account for multiple lease components of a contract as a single lease c omponent, if it meets the conditions provided in Section 8.2.2.1. Comparison with AS 19: AS 19 does not contain any guidance on separation of lease and non-lease components. It seems that AS 19 requires accounting for the entire contract including the non-lease components. The Scope of AS 19 mentions that “AS 19 applies to contracts that transfer the right to use assets even though substantial services by the lessor may be called for in connection with the operation or maintenance of such assets. Examples include the supply of property, vehicles, and computers.” Hence, one would be required to account for the entire contract as a lease under AS 19, without separating the non-lease components. 8.2.2.3 Determining and allocating the consideration in the contract – Lessee Lessees that do not make an accounting policy election (by class of underlying asset) to use the practical expedient, as discussed above, to account for each separate lease component of a contract and any associated non-lease components as a single lease component, are required to allocate the consideration in the contract to the lease and non-lease components on a RELATIVE STAND-ALONE PRICE BASIS. Lessees are required to use observable stand-alone prices (i.e., prices at which a customer would purchase a component of a contract separately) when available. If observable stand -alone prices are not readily available, lessees estimate stand-alone prices, maximizing the use of observable information. Illustration 14 - Activities which are not components of a lease contract Scenario A: A lessee enters into a five-year lease of equipment, with fixed annual payments of ` 10,000. The contract contains fixed annual payments as follows: ` 8,000 for rent, ` 1,500 for maintenance and ` 500 for administrative tasks. Explain how the consideration would be allocated.  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  6.392 2. FINANCIAL REPORTING  392 Scenario B: Assume the fact pattern as in scenario A except that, in addition, the contract requires the lessee to pay for the restoration of the equipment to its original condition. Explain how the consideration would be allocated. Solution: Scenario A: The contract contains two components, viz., a lease component (lease of equipment) and a non- lease component (maintenance). The amount paid for administrative tasks does not transfer a good or service to the lessee. Assuming that the lessee does not elect to use the practical expedient as per para 15 of Ind AS 116, both the lessee and the lessor account for the lease of equipment and maintenance components separately and the administration charge is included in the to tal consideration to be allocated between those components. Therefore, the total consideration in the contract of ` 50,000 will be allocated to the lease component (equipment) and the non -lease component (maintenance). Scenario B: The contract still contains two components, viz., a lease component (lease of equipment) and a non-lease component (maintenance). Similar to the amount paid for administrative tasks, the restoration does not transfer a good or service to the lessee as it is only performed at th e end of the lease term. Therefore, the total consideration in the contract of ` 50,000 will be allocated to the lease component (equipment) and the non-lease component (maintenance). ***** Illustration 15 - Allocating contract consideration to lease and non-lease components – Lessees A lessee enters into a lease of equipment. The contract stipulates the lessor will perform maintenance of the leased equipment and receive consideration for that maintenance service. The contract includes the following fixed prices for the lease and non-lease component: Lease ` 80,000 Maintenance ` 10,000 Total ` 90,000 Assume the stand-alone prices cannot be readily observed, so the lessee makes estimates, maximizing the use of observable information, of the lease and non-lease components, as  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  INDIAN ACCOUNTING STANDARD 116   6.393     follows: Lease ` 85,000 Maintenance ` 15,000 Total ` 1,00,000 In the given scenario, assuming lessee has not opted the practical expedient, explain how will the lessee allocate the consideration to lease and non-lease component? Solution: The stand-alone price for the lease component represents 85% (i.e., ` 85,000 / ` 1,00,000) of total estimated stand-alone prices. The lessee allocates the consideration in the contract (i.e., ` 90,000), as follows: Lease * ` 76,500 Maintenance ** ` 13,500 Total ` 90,000 * ` 90,000 x 85% ** ` 90,000 x 15%. ***** 8.2.2.4 Determining and allocating the consideration in the contract – Lessors: Lessors are required to allocate the consideration in the contract to the lease and any associated non-lease components by applying paragraphs 73 – 90 of Ind AS 115 Revenue from Contracts with Customers. 8.2.3 Contract Combinations Ind AS 116 requires that two or more contracts entered into at or near the same time with the same counterparty (or related parties of the counterparty) be considered a ‘single’ contract IF ANY ONE of the following criteria is met: The rights to use the The contracts are underlying assets negotiated as a conveyed in the contracts The amount of package with an (or some of the rights to consideration to be overall commercial use underlying assets paid in one contract KZ objective that cannot KZ conveyed in each of the  depends on the price contracts) are a single be understood or performance of lease component without  considering the other contract the contracts together   © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  6.394 2. FINANCIAL REPORTING  394 8.2.4 Portfolio Application Ind AS 116 applies to individual leases. However, entities that have a large number of leases of similar assets (for e.g., leases of a fleet of similar rolling stock) may face practical challenges in applying the leases model on a lease-by-lease basis. Thus, Ind AS 116 includes a practical expedient that allows entities to use a portfolio approach for leases with similar characteristics if the entity reasonably expects that the effects on the financial statements would not differ materially from the application of the standard to the individual leases in that portfolio. If accounting for a portfolio, an entity uses estimates and assumptions that reflect the size and composition of the portfolio. This approach is consistent with that under Ind AS 115. A decision to use the portfolio approach would be similar to a decision some entities make today to expense, rather capitalise, certain assets when the accounting difference is, and would continue to be, immaterial to the financial statements. Comparison with AS 19: AS 19 does not provide any guidance on combining contracts or portfolio application of principles. 8.3 KEY CONCEPTS 8.3.1 Inception and Commencement of Lease Ind AS 116 requires customers and suppliers to determine whether a contract is or contains a lease at the inception of the contract. The inception date is defined as the earlier of the following dates:  date of a lease agreement  date of commitment by the parties to the principal terms and conditions of the lease Date of a lease agreement Whichever date is earlier Inception date of a lease Date of commitment by the parties to the principal terms and conditions of the lease  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  INDIAN ACCOUNTING STANDARD 116   6.395     The commencement date is defined as the date on which a lessor makes an underlying asset available for use by a lessee. Where, the ‘underlying asset’ is an asset that is the subject of a lease, for which the right to use that asset has been provided by a less or to a lessee. In certain cases, the commencement date of the lease may be before the date stipulated in the lease agreement (for e.g., the date on which rents become due and payable). This often occurs when the leased space is modified by the lessee prior to commencing operations in the leased space (for e.g., during the period a lessee uses the leased space to construct its own leasehold improvements). If a lessee takes possession of, or is given control over, the use of the underlying asset before it begins operations or making lease payments under the terms of the lease, the lease term has commenced even if the lessee is not required to pay rent or the lease arrangement states the lease commencement date is a later date. The timing of when lease payments begin under the contract does not affect the commencement date of the lease. As discussed earlier, inception date is the date when an entity shall assess if the contract is or contains lease. While the commencement date is relevant because on that date: (i) a lessee (except where the exemption of short-term lease or low-value asset is taken) initially recognises a lease liability and related Right of Use Asset (hereinafter referred to as “ROU Asset”) on the commencement date (ii) a lessor (for finance leases) initially recognises its net investment in the lease on the commencement date. Where, ‘ROU Asset’ is defined as an asset that represents a lessee’s right to use an underlying asset for the lease term.  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  6.396 2. FINANCIAL REPORTING  396 Commencement date of a lease On this date The commencement date is the date on which a lessor makes an underlying asset* available for use by a lessee a lessee initially recognises a lessor (for finance leases) initially a lease liability and recognizes *The ‘underlying related Right of Use its net investment in asset’ is an asset that Asset (ROU Asset)* is the subject of a the lease lease, for which the right to use that asset has been provided by *‘ROU Asset’ represents a lessee’s a lessor to a lessee right to use an underlying asset for  the lease term Note: In certain cases, the commencement date of the lease may be before the date stipulated in the lease agreement. The timing of when lease payments begin under the contract does not affect the commencement date of the lease. 8.3.2 Lease Term Determination of the lease term is a very crucial step before the calculation of the Lease Liability and the corresponding ROU Asset. In simple terms, lease term is the summation of the following: Particulars Years 1 Rent free period XXX 2 Non-cancellable period XXX  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  INDIAN ACCOUNTING STANDARD 116   6.397     3 Optional renewable periods (where lessee is reasonably certain to extend the XXX lease) 4 Periods covered by option to terminate the lease (where lessee is reasonably certain not to terminate early) XXX Total Lease terms XXXX The lease term begins at the lease commencement date. The lease term starts when the lessor makes the underlying asset available for use by the lessee and includes any rent-free periods provided. The assessment of whether it is reasonably certain that a lessee will exercise an extension or termination option should be done on lease commencement date. An entity should consider all relevant facts and circumstances that create an economic incentive for the lessee to exercise, or not to exercise, the option, including any expected changes in facts and circumstances from the commencement date until the exercise date of the option. The assessment should not be based solely on the lessee’s intentions, past practices, or estimates. It should focus on the factors that create an economic incentive for the lessee, including contract, asset, entity, or market -based factors. Example of relevant factors to consider are: Contractual terms vis-a vis market rates Asset related factors 1. Lease rentals in optional period, ex. Termination 1. Specialised asset penalties and residual value guarantees 2. Variable or contingent payment 2. Location of underlying asset 3. Terms and condition after initial optional period, 3. Availability of suitable ex. Purchase option alternatives 4. Cost relating to the termination of the lease and 4. Existence of significant signing of new replacement lease leasehold improvement In certain cases, it can be more difficult to determine whether the exercise of the option is reasonably certain where the period from the commencement of the lease to the exercise date of an option is longer. The said difficulty arises from several factors. For e.g., a lessee’s estimates of its future needs for the leased asset become less precise the further into the future the forecast goes. Also, the future fair value of certain assets such as those involving technology is more difficult to predict than the future fair value of a relatively stable asset, such as a fully leased commercial office building located in a prime area. An artificially short lease term (for e.g., a lease of a corporate headquarters, distribution facility, manufacturing plant or other key property with a four-year lease term), may effectively create a  © The Institute of Chartered Accountants of India ^ĞŶƐŝƚŝǀŝƚLJ͗WƵďůŝĐ;ϰͿ  6.398 2. FINANCIAL REPORTING  398 significant economic incentive for the lessee to exercise a purchase or renewal o